[Please forgive my lack of focus on Arizona specific real estate issues lately. I’m totally captured by The Bailout and trying to figure out the possible consequences for Arizona home buyers and Arizona home sellers.]

The problem is still falling house prices

That title of a Wall Street Journal opinion piece from Martin Feldstein pretty much sums up my position on the credit crisis.

A successful plan to stabilize the U.S. economy and prevent a deep global recession must do more than buy back impaired debt from financial institutions. It must address the fundamental cause of the crisis: the downward spiral of house prices that devastates household wealth and destroys the capital of financial institutions that hold mortgages and mortgage-backed securities.

The recently enacted financial rescue plan does nothing to stop this spiral. Credit will not flow and liquidity will not return to the banking system until financial institutions have confidence in the solvency and liquidity of other banks. [I added the bolding.]

Financial institutions will not regain confidence in the solvency of other institutions that hold mortgages until after home prices stop falling.

Overshooting on the way down

Because of the 20% fall in the price of homes since the bursting of the house-price bubble, there are now some 10 million homes with mortgages that exceed the value of the house. Residential mortgages are generally “no recourse” loans, meaning that if the homeowner stops making payments, the creditor can take the property but cannot take other assets or attach income. Individuals with loan-to-value ratios greater than 100% therefore have an incentive to default even if they can afford their monthly payments, and to rent an apartment or other house until house prices stop declining. When individuals default and creditors foreclose, the property is added to the stock of unsold homes. That depresses prices further, increasing the number and magnitude of negative equity houses.

The Bailout won’t make under-water mortgages profitable nor will it stop those mortgages from continuing to lose value.

I’m not sure if I buy the author’s proposed solution, however, I think he did a great job of defining the problem.

Fed’s purchase mechanism and arbitrary pricing

On the Fed’s purchase mechanism, my suspicion is the Fed will overpay for mortgages in order to help the banks.

There are also important technical problems in using the $700 billion fund to buy impaired securities. The Treasury’s preliminary idea was to use a “reverse auction,” a method that works well when used to buy a single homogeneous security (like a firm buying back its own shares). But that is not feasible for buying the impaired securities, because of the enormous variety of underlying mortgages and of the almost limitless number of different derivatives based on those mortgages. The buyback will therefore involve a large number of arbitrary valuation decisions by the Treasury staff and their investment-banker advisers.

“Arbitrary pricing” also means the government will likely overpay for many, perhaps most, of the mortgages they buy, and it will be difficult to prove they overpaid.

The features that Congress added to the initial Treasury plan do nothing to achieve sustained confidence in the financial institutions. They provide Congressional oversight, delay the use of funds, create partial government equity ownership in some firms and do other things to protect taxpayers. But they do not address falling home prices. [I added the bolding.]

ADDED: Here is a video of Martin Feldstein talking about his ideas on the financial crisis. Boy, is he not an animated speaker!